For the Jakarta Globe, 2 March 2011
Bank Indonesia last month made the right move in raising its interest rate from a record low. The debate now is whether the central bank should raise the rate further to tame rising inflation in Indonesia.
One theory suggests that a higher interest rate will attract people to save more, thus discouraging borrowing and spending. A higher interest rate thus would be expected to reduce aggregate demand in the economy and, as a result, slow rising prices. The bank’s new interest rate is 6.75 percent, still lower than the annual rate of inflation, which stood at 7 percent in January and 6.8 percent in February. Based on this reasoning, the central bank should raise rates again in its policy review this Friday.
Another theory says the current interest rate is already high. With the rate of borrowing thus increased, the thinking goes, credit expansion will slow and profit in the banking sector will decline. Investors will suffer and reduce their investments, and economic growth will slow.
This theory assumes that consumption is good for the economy. The more people spend on consumption — even if it is made possible by borrowing — the higher the growth of the economy. It also supports expanded credit in sectors like banking and finance to speed up economic growth. The more society borrows and spends, the better off the economy.
Expansion of credit also helps speculative behavior, encouraging customers to borrow money to buy increasingly expensive commodities. The expectation of higher prices will increase speculation and drive prices up further. For example, with a low interest rate, house builders are encouraged to borrow to build more houses and promise customers they will also get low interest on their credit — and that the customers will be able to resell the houses at much higher prices. Here, a higher interest rate is thus considered bad for the economy, because it will deter positive speculative behavior. Unfortunately, those who believe in this theory often forget that all financial crises have been preceded by rising inflation and speculation, including the recent property bubbles.
Another, contrasting theory, uses the perspective of the financial health of an individual. This theory starts from a belief that people should only spend what they have. Borrowing is only encouraged when it is used for production, rather than consumption and speculation. Otherwise, people are advised to borrow only during emergencies. Adherents maintain that this thrifty consumption habit will strengthen the financial health of an individual. A society with thrifty individuals is less likely to be consumptive and speculative and, in turn, is more likely to avoid financial crises.
In Indonesia, this theory would hold that the current interest rate has been too low and that society has become trapped in too much debt. As a result, people may have spent most of what they have because they do not see any value in saving. The interest rate on their savings is too low compared with the inflation rate. Therefore, saving — depositing money in the bank — actually means that the relative value of their money will decrease over time. In this situation, people may prefer to borrow and spend and speculate because the prices of commodities will rise anyway while the interest rate on their savings is too low.
In this consumptive and speculative economy, it is hard for people to save for the future. It is hard to save money for their children’s education or for their own retirement. The situation is made even worse by the fact that Indonesia does not have a comprehensive social security system.
Therefore, the decision to raise the interest rate is a move in the right direction, though it should be raised again to even higher than the inflation rate. People will then be encouraged to save for the future, and consumptive as well as speculative behavior will be discouraged.
The central bank could also use a pro-poor policy by giving a higher interest rate to deposits from low-income earners, as inflation is also usually higher among these groups.
Finally, Indonesians should not continually be pushed to be more consumptive and speculative, particularly if such behavior is financed by credit. We should promote the habit of saving for the future and avoiding excessive credit and speculative behavior. The banking and other financial sectors should also slow down the expansion of credit, including aggressive marketing to potential customers who are relatively illiterate in financial issues. This thrifty behavior will be good in the long run for Indonesians individually and for the economy as a whole because it will reduce the possibility of another financial crisis. (*)